Original post on Investopedia.
Whether the goal is to achieve capital preservation or aggressively generate growth, a successful retirement savings plan requires establishing an appropriate asset allocation strategy. Putting all your retirement funds into a savings account can be safe, but in order to build meaningful wealth, investors need to find an account that can deliver a return above the current rate of inflation. On the other hand, investing in assets other than cash can be an effective way to outperform inflation and generate regular income. Alternative investments, one such asset category, have the potential to generate attractive returns with the added benefit of protecting a portfolio from market volatility.
Defining Asset Types
Assets can be broadly categorized into two different types: traditional and alternative. Stocks, bonds, cash, and cash equivalents comprise traditional assets. Alternative investments consist of investment strategies such as private equity, venture capital, real assets, and hedge funds. These assets are illiquid, meaning investors are unable to redeem them as readily as they can public equities and bonds. Alternative investments are also private, and as such, not publicly listed on an exchange.
Diversification Through Alternative Investments
The financial crisis of 2008 and corresponding market turmoil drastically reduced the retirement savings of many individuals. As a result, investors have turned towards alternative investments as a way to dampen volatility and achieve uncorrelated returns. Generally speaking, assets that feature low correlation with one another produce more opportunities for diversification. Since alternatives are non-traditional investments, they do not tend to move in the direction of the public markets. Hedge funds, for instance, are able to invest across various markets using a wide array of instruments. Real assets, such as timberland, also exemplify how correlation relates to portfolio diversification. Since their risk lies outside financial markets (think natural disasters), these investments can be insulated from market fluctuations and their return characteristics are different than that of the public markets.
As such, alternative investments can provide different sources of capital growth that might not drawdown as severely when the markets sell off. As an example, historically, hedge funds experienced less severe drawdowns, or declines, during bear markets. This is why they are able to provide a degree of downside protection when the markets are not doing so well. In a bear market, many but not all equity hedge funds will lose money. In the same market condition, ALL traditional equity funds will lose money. The aim of hedge funds is not always to have high short-term returns, but to offer protection during these drawdowns and generate long-term, consistent returns over time.
Illiquidity Advantage
Illiquidity is a crucial factor to consider when incorporating alternatives in an investment portfolio. It can sometimes take years to realize returns from these investments, as it takes time to source the right investment opportunities, improve underlying investments, and successfully liquidate them. Depending on an investor’s time horizon and need for liquidity, some alternative investment options may be more appropriate than others.
Hedge funds, for instance, typically have shorter lockup periods than venture capital or private equity investments. A hedge fund investment may require a lockup shorter than a year, while certain venture capital and private equity investments can take longer than ten years to realize returns. However, illiquid returns have been known to generate a return premium compared to their liquid counterparts, of more than 3% annually. This “illiquidity premium” provides compensation for the loss of investment flexibility and liquidity associated with the investment. While there is no established causal relationship between degree of liquidity and expected returns, a wealth of literature and research suggest a correlation between the two factors indeed exists.
Alternative Investments as Extensions of Traditional Assets
A simple way to conceptualize alternative investments is to consider them as extensions of their traditional asset counterparts. For instance, long/short equity hedge funds, venture capital, and private equity are alternative investment strategies that can be thought of as less liquid extensions of equity ETF’s and actively managed mutual funds. All of these investment types share some related risk and return characteristics derived from the overarching “equity” asset class. Younger investors who are more aggressive with their investment decisions and have longer time horizons may consider supplementing their equity investments with one or more of the aforementioned three alternatives. Conversely, investors approaching retirement age with a focus on capital preservation and fixed income may want to consider credit hedge funds in addition to their traditional bond allocations.
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